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380 Part 1 Financial Accounting

ILLUSTRATION 133 Summary of Ratios

State Discussed
Name of Ratio Formula Results as in Chapter

Overall Performance Measures


Market price per share
1. Price/earnings ratio Times 13
Net income per share
Net income Interest (1 Tax rate)
2. Return on assets Percent 13
Total asssets
Net income Interest (1 Tax rate)
3. Return on invested capital Percent 13
Long-term liabilities Shareholders equity
Net income
4. Return on shareholders equity Percent 13
Shareholders equity
Profitability Measures
Gross margin
5. Gross margin percentage Percent 6, 13
Net sales revenues
Net income
6. Profit margin Percent 13
Net sales revenues
Net income
7. Earnings per share Dollars 9
No. shares outstanding
Cash generated by operations
8. Cash Realization Times 11
Net income
Tests of Investment Utilization
Sal es revenues
9. Asset turnover Times 13
Total assets
Sales revenues
10. Invested capital turnover Times 13
Long-term liabilities Shareholders equity
Sales revenues
11. Equity turnover Times 13
Shareholders equity
Sales revenues
12. Capital intensity Times 13
Property, plant, and equipment
Cash
13. Days cash Days 5
Cash expenses 365
Accounts receivable
14. Days receivables (or collection period) Days 5
Sales 365
Inventory
15. Days inventory Days 6
Cost of sales 365
Cost of sales
16. Inventory turnover Times 6
Inventory
Sa les revenues
17. Working capital turnover Times 13
Working capital
Current assets
18. Current ratio Ratio 5
Current liabilities
Monetary current assets
19. Acid-test (quick) ratio Ratio 5
Current liabilities
(continued)
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Chapter 13 Financial Statement Analysis 381

ILLUSTRATION 133 (concluded )

State Discussed
Name of Ratio Formula Results as in Chapter

Tests of Financial Condition


Assets
20. Financial leverage ratio Times 13
Shareholders equity
Long-term liabilities
21. Debt/equity ratio Percent 8
Shareholders equity
or
Total liabilities
Percent 8
Shareholders equity
Long-term liabilities
22. Debt/capitalization Percent 8
Long-term liabilities Shareholders equity
Pretax operating profit Interest
23. Times interest earned Times 9
Interest
Cash generated operations
24. Cash flow/debt Percent 11
Total debt
Tests of Dividend Policy
Dividends per share
25. Dividend yield Percent 13
Market price per share
Dividends
26. Dividend payout Percent 13
Net income
Notes:
1. Averaging. When one term of a formula is an income statement item and the other term is a balance sheet item, it is often preferable to use the average of the beginning and
ending balance sheet amounts rather than the ending balance sheet amounts.
2. Tangible assets. Ratios involving noncurrent assets or total assets often exclude intangible assets such as goodwill and trademarks. When this is done, the word tangible is
usually used in identifying the ratio.
3. Debt. Debt ratios may exclude accounts payable, accrued liabilities, deferred income taxes, and other noninterest-bearing liabilities. The reader often has no way of knowing
whether this has been done, however. Conceptually, debt means interest-bearing liabilities.
4. Coverage ratios. Times interest earned and other coverage ratios can be calculated using pretax cash generated by operations instead of pretax operating profit.

Growth Measures
Analysts are also interested in the growth rate of certain key items such as sales, net in-
come, and earnings per share. These rates are often compared with the rate of inflation to
see if the company is keeping pace with inflation or experiencing real growth. Common
growth rate calculations include average growth rate and compound growth rate. Both
involve looking at information over a period of years, typically 5 or 10. The calculations
will be illustrated using Franklins 20052010 sales data (expressed in millions):

2010 2009 2008 2007 2006 2005


Net sales $6,295 $6,191 $5,787 $5,181 $4,652 $4,349

To calculate average growth rate, growth is first calculated on a year-to-year basis.


From 2005 to 2006, this was 6.97 percent ($4,652 $4,349 100 percent); from
2006 to 2007, 11.37 percent; and so on. These five year-to-year rates are then averaged;
the result is an average growth rate in sales of 7.74 percent.
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340 Part 1 Financial Accounting

incurred $10,000 monthly being in business costs but did not strictly enforce these credit terms with the
(so-called fixed costs) irrespective of the months vol- result that customers seemed to be taking an additional
ume. The company sold its product for $55 each. month to pay. All of the companys costs were paid in
As of December 31, Reinholz had been producing cash in the month in which they were incurred.
Castles and Unicorns for three months using rented Reinholzs predictions came true. By March, sales
facilities. The balance sheet on that date was as follows: had reached 2,000 Castles and Unicorns, and 2,500
units were produced in March for April sale. Total
profit for the year by March 31 had reached $60,000.
MEDIEVAL ADVENTURES COMPANY
Balance Sheet In order to get a respite from the increasingly hectic
As of December 31 activities of running the business, in mid-April Rein-
holz went on a family vacation.
Assets
Within the week, the companys bookkeeper called.
Cash $146,250
Medieval Adventures bank balance was almost zero,
Accounts receivable 68,750
so necessary materials could not be purchased. Unless
Inventory 35,000
_________ Reinholz returned immediately to raise more cash, the
$250,000
_________ entire operation would have to shut down within a few
_________
Equities days.
Common stock $250,000
Retained earnings 0
_________ Questions
$250,000
_________
_________
1. Prepare monthly income statements, balance
Reinholz was very pleased to be operating at a sheets, and cash budgets based on sales increases of
profit in such a short time. December sales had been 500 units per month and 30-day advance produc-
750 units, up from 500 in November, enough to report tion for January through September. When will the
a profit for the month and to eliminate the deficit accu- company need extra funds? How much will be
mulated in October and November. Sales were ex- needed? When can a short-term loan to cover the
pected to be 1,000 units in January, and Reinholzs need be repaid?
projections showed sales increases of 500 units per 2. How is it possible that a company starts with
month after that. Thus, by May monthly sales were ex- $250,000 in capital and has profitable sales for a
pected to be 3,000 units. By September that figure period of six months and still ends up with a zero
would be 5,000 units. bank balance? Why did Medieval Adventures need
Reinholz was very conscious of developing good money in April? How could this need have been
sales channel relationships in order to increase sales, avoided?
so Castles and Unicorns deliveries were always 3. From your calculations and financial statements for
prompt. This required production schedules 30 days in Question 1, derive cash flow statements for the
advance of predicted sales. For example, Medieval Ad- months of March, May, and July from each months
ventures had produced 1,000 Castles and Unicorns beginning and ending balance sheets and income
in December for January sales, and would produce statement. Compare these derived cash flow state-
1,500 in January for Februarys demand. The company ments with the cash budgets prepared directly in
billed its customers with stated terms of 30 days net, Question 1.

Case 112
Amerbran Company (A)*
Amerbran Company was a diversified company that bacco, distilled products, and personal care products
sold various consumer products, including food, to- and financial services. Financial statements for the
* Copyright James S. Reece. company are shown in Exhibit 1.
352
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Chapter 11 The Statement of Cash Flows 341

EXHIBIT 1

AMERBRAN COMPANY
Balance Sheets As of December 31, 20x1 and 20x0
(in thousands)

20x1 20x0

Assets
Cash $ 28,912 $ 23,952
Accounts receivable 756,152 687,325
Inventories 1,244,912 1,225,402
Prepaid expenses 76,140
__________ 77,167
__________
Total current assets 2,106,116 2,013,846
Investments 1,116,534
__________ 1,058,637
__________
Property, plant, and equipment, at cost 1,566,268 1,366,719
Less accumulated depreciation 723,442
__________ 645,734
__________
Net property, plant, and equipment 842,826 720,985
Goodwill 645,210 577,606
Other assets 115,826
__________ 62,374
__________
Total assets $4,826,512
__________ $4,433,448
__________
__________ __________
Liabilities and Shareholders Equity
Accounts payable $ 271,452 $ 238,377
Short-term debt 430,776 351,112
Accrued expenses payable 922,990
__________ 728,262
__________
Total current liabilities 1,625,218 1,317,751
Long-term liabilities 880,674
__________ 932,828
__________
Total liabilities 2,505,892
__________ 2,250,579
__________
Convertible preferred stock 33,828 42,611
Common stock, at par 322,834 161,417
Additional paid-in capital 53,641 57,072
Treasury stock, at cost (110,948) (102,705)
Retained earnings 2,021,265
__________ 2,024,474
__________
Total shareholders equity 2,320,620
__________ 2,182,869
__________
Total liabilities and shareholders equity $4,826,512
__________
__________ $4,433,448
__________
__________

Income Statement
For the year ended December 31, 20x1
(in thousands)

Sales revenues, net $7,622,677


_ _________
Cost of sales 2,803,623
Excise taxes on goods sold __2,887,616
_________
Gross margin 1,931,438
Selling, general, and administrative expenses 1,328,107
___
________
Income before income taxes 603,331
Provision for income taxes 274,558
___________
Net income $___________
328,773
___________
402
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390 Part 1 Financial Accounting

EXHIBIT 2 2011 2010


Selected Ratios
Acid-test ratio 0.671 0.556
Current ratio 1.172 1.088
Inventory turnover (times) 10.005 8.400
Days receivables 39.66 27.17
Gross margin percentage 15.12 16.50
Profit margin percentage 2.831 4.090
Invested capital turnover (times) 2.091 2.355
Debt/equity ratio (percentage) 62.15 40.68
Return on shareholders equity ? 13.55

Case 132
Amerbran Company (B)*
Using the 20x1 financial statements in Amerbran data. The companys interest expense in 20x0 and
Company (A), Case 112, together with the 20x0 in- 20x1 was (in thousands) $105,165 and $102,791,
come statement shown in Exhibit 1 below, calculate respectively.
the ratios listed below for 20x0 and 20x1. Use year-
end amounts for ratios that involve balance sheet 1. Return on assets.
2. Return on equity.
3. Gross margin percentage.
EXHIBIT 1 4. Return on sales.
5. Asset turnover.
AMERBRAN COMPANY 6. Days cash (20x1 only).
Income Statement 7. Days receivables.
For the Year Ended December 31, 20x0
(in thousands) 8. Days inventories.
9. Inventory turnover.
Sales revenue, net $6,577,480
__________ 10. Current ratio.
Cost of sales 2,573,350
11. Acid-test ratio.
Excise taxes on goods sold 2,354,350
__________
12. Debt/capitalization ratio.
Gross margin 1,649,780
13. Times interest earned.
Selling, general, and
administrative expenses 974,121
__________
Income before income taxes 675,659 Questions
Provision for income taxes 296,877
__________
Net income $__________
378,782 1. Comment on Amerbrans treatment of excise taxes
__________
as part of the calculation of gross margin.
2. As an outside analyst, what questions would you
want to ask Amerbrans management based on the
* Copyright James S. Reece. ratios you have calculated?